Can somebody help me understand how to do this? The Comprehensive Problem: The Landis Corporation had 2008 sales of $100 million. The balance sheet items that
vary directly with sales and the profit margin are as follows:
Percent
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . 15
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Net fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . 40
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . 15
Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Profit margin after taxes . . . . . . . . . . . . . . . . . . 6%
The dividend payout rate is 50 percent of earnings, and the balance in retained earnings
at the end of 2008 was $33 million. Common stock and the company’s long-term
bonds are constant at $10 million and $5 million, respectively. Notes payable are currently
$12 million.
a. How much additional external capital will be required for next year if sales
increase 15 percent? (Assume that the company is already operating at full
capacity.)
b. What will happen to external fund requirements if Landis Corporation reduces
the payout ratio, grows at a slower rate, or suffers a decline in its profit margin?
Discuss each of these separately.
c. Prepare a pro forma balance sheet for 2009 assuming that any external funds
being acquired will be in the form of notes payable. Disregard the information in
part b in answering this question (that is, use the original information and part a
in constructing your pro forma balance sheet).
To calculate the additional external capital required for next year, you need to determine how the balance sheet items that vary directly with sales will change with a 15% increase in sales. These items include cash, accounts receivable, inventory, accounts payable, and accruals.
a. First, calculate the increase in sales:
Sales increase = 15% * $100 million = $15 million
Next, determine the increase in each balance sheet item based on the given percentage:
Cash increase = 5% * $15 million = $0.75 million
Accounts receivable increase = 15% * $15 million = $2.25 million
Inventory increase = 25% * $15 million = $3.75 million
Accounts payable increase = 15% * $15 million = $2.25 million
Accruals increase = 10% * $15 million = $1.5 million
Finally, calculate the total additional external capital required:
Additional external capital = Cash increase + Accounts receivable increase + Inventory increase + Accounts payable increase + Accruals increase
Additional external capital = $0.75 million + $2.25 million + $3.75 million + $2.25 million + $1.5 million
Additional external capital = $10.5 million
Therefore, if sales increase by 15%, the Landis Corporation will require an additional $10.5 million of external capital.
b. To analyze the impact of reducing the payout ratio, growing at a slower rate, or suffering a decline in profit margin on external fund requirements, you need to understand their effects on retained earnings.
Reduction in the payout ratio: If the dividend payout ratio is reduced, it means that a smaller portion of earnings will be paid out as dividends, resulting in higher retained earnings. This increase in retained earnings will reduce the need for external funds.
Slower growth rate: A slower growth rate means that the increase in sales will be smaller, resulting in lesser need for additional external capital.
Decline in profit margin: A decline in profit margin means that the company's profitability decreases. This will result in lower earnings, which will reduce retained earnings and increase the need for external funds.
c. To prepare a pro forma balance sheet for 2009 assuming that any external funds acquired will be in the form of notes payable, you need to incorporate the changes in the balance sheet items calculated in part a.
Start with the original balance sheet:
Assets:
Cash
Accounts receivable
Inventory
Net fixed assets
Liabilities and Equity:
Accounts payable
Accruals
Long-term bonds
Notes payable
Common stock
Retained earnings
Now, incorporate the changes calculated in part a by adding the increases to their respective balance sheet items.
Finally, adjust the retained earnings by taking into account the dividend payout rate and the new earnings. The new retained earnings will be the previous retained earnings plus the new earnings, minus the dividends paid out.
The resulting pro forma balance sheet will reflect the changes in balance sheet items and the adjusted retained earnings. Disregard the information in part b when constructing your pro forma balance sheet.
To calculate the additional external capital required for next year, considering a 15% increase in sales, you need to determine the change in each balance sheet item that varies directly with sales. Here's how you can do it step-by-step:
Step 1: Calculate the change in sales
Increase in sales = 15% * $100 million = $15 million
Step 2: Calculate the change in each balance sheet item
Cash = 5% * $15 million = $0.75 million
Accounts receivable = 15% * $15 million = $2.25 million
Inventory = 25% * $15 million = $3.75 million
Net fixed assets = 40% * $15 million = $6 million
Accounts payable = 15% * $15 million = $2.25 million
Accruals = 10% * $15 million = $1.5 million
Step 3: Calculate the change in retained earnings
Profit margin after taxes = 6% * $100 million = $6 million
Dividend payout rate = 50% * $6 million = $3 million
Change in retained earnings = $6 million - $3 million = $3 million
Step 4: Calculate the total change in liabilities and equity
Change in notes payable = additional external capital required
Change in notes payable = ($0.75 million + $2.25 million + $3.75 million + $2.25 million + $1.5 million) - $3 million
Change in notes payable = $8.5 million - $3 million
Change in notes payable = $5.5 million
Therefore, an additional $5.5 million in external capital will be required for next year if sales increase by 15%.
Now, let's discuss part b:
1. If Landis Corporation reduces the dividend payout ratio:
- A lower dividend payout ratio means that more earnings will be retained in the company.
- This will increase the retained earnings, resulting in a decrease in the external fund requirements.
- Since the retained earnings at the end of 2008 were $33 million, a lower dividend payout ratio would increase this amount, reducing the need for external capital.
2. If Landis Corporation grows at a slower rate:
- A slower growth rate would result in a smaller increase in sales.
- With lower sales growth, the change in the balance sheet items would be smaller, reducing the external fund requirements.
3. If Landis Corporation suffers a decline in profit margin:
- A decline in the profit margin means that the company's earnings after taxes will be lower.
- This will lead to a decrease in retained earnings, increasing the external fund requirements.
- The change in retained earnings will be negative, resulting in a higher need for external capital.
Finally, let's prepare a pro forma balance sheet for 2009, assuming any external funds acquired will be in the form of notes payable (disregarding part b):
Pro Forma Balance Sheet for 2009:
Assets:
Cash = $0.75 million (original) + $0.75 million (additional external capital from notes payable)
Accounts receivable = $2.25 million (original) + $2.25 million (additional external capital from notes payable)
Inventory = $3.75 million (original) + $3.75 million (additional external capital from notes payable)
Net fixed assets = $6 million (original) + $6 million (additional external capital from notes payable)
Liabilities and Equity:
Accounts payable = $2.25 million (original) + $2.25 million (additional external capital from notes payable)
Accruals = $1.5 million (original) + $1.5 million (additional external capital from notes payable)
Notes payable = $12 million (original) + $5.5 million (additional external capital from notes payable)
Common stock = $10 million (constant)
Long-term bonds = $5 million (constant)
Retained earnings = $33 million (original) + $3 million (change in retained earnings)
Please note that this pro forma balance sheet assumes that the additional external capital will be acquired through notes payable and does not consider any changes resulting from part b of the question.